Overview of Colored Coins

Meni Rosenfeld

December 4, 2012

Abstract

Bitcoin ([3]) is the world’s first decentralized digital currency, allowing the easy storageand transfer of cryptographic tokens. It uses a peer-to-peer network to carry information,hashing as a synchronization signal to prevent double-spending, and a powerful scriptingsystem to determine ownership of the tokens. There is a growing technology and businessinfrastructure supporting it.

By the original design bitcoins are fungible, acting as a neutral medium of exchange.However, by carefully tracking the origin of a given bitcoin, it is possible to color a set ofcoins to distinguish it from the rest. These coins can then have special properties supportedby either an issuing agent or a Schelling point, and have value independent of the face valueof the underlying bitcoins. Such colored bitcoins can be used for alternative currencies,commodity certificates, smart property, and other financial instruments such as stocks andbonds.

Because colored bitcoins make use of the existing Bitcoin infrastructure and can be storedand transferred without the need for a third party, and even be exchanged for one another inan atomic transaction, they can open the way for the decentralized exchange of things thatare not possible by traditional methods. In this paper we will discuss the implementationdetails of colored bitcoins and some of their use cases.

Contents

1 Introduction 1

2 Merits of colored coins 32.1 List of benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32.2 Comparison with alternative methods . . . . . . . . . . . . . . . . . . . . . . 42.3 Demerits of colored coins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

3 Implementation overview 7

Bibliography 10

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Chapter 1

Introduction

Bitcoin has revolutionized currency by creating a medium of exchange that can stored andtransferred digitally without reliance on any single third party, with overreaching implicationsfor efficiency, security and counterparty risk. The colored coins project aims to extend theseabilities to other assets; it would allow handling arbitrary digital tokens in much the sameway that bitcoins are handled, and in particular easily trading them for digital currencies.Some potential uses are:

1. Smart property: Ownership of physical assets such as cars and cellphones can berepresented as a token, and the device will only respond to the owner of the token.([1])

2. Company stock: A company could issue tokens representing shares in the company.The platform would easily allow sending Bitcoin dividends to shareholders, and allowshareholders to cryptographically vote.

3. Deterministic contracts: A person or company can issue contracts specifying aparticular future payment, such as a mining bond or a commodity option.

4. Bonds: A special case of the above, bonds can be issued with a particular face valueand repayment schedule, denominated in bitcoins or some other currency or commodity.

5. Demand deposits: Similar to bonds, except the issuer guarantees to redeem thetoken for its face value at any time. This can be used as either an interest bearinginstrument, or as a way to handle physical assets more efficiently.

6. Emergent currencies: A community may want to use a local currency which issimilar technically to Bitcoin but detached from it monetarily. They can issue tokensfor this purpose and distribute them among themselves in some fashion, and have themgain value organically through use rather than through some concrete backing.

7. Decentralized digital representation of physical assets: This is a hypotheticaluse case that is not proven to be viable, but is eagerly anticipated by some groups. Over

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time, a consensus could arise that a token is commensurable in value to some traditionalcurrency or commodity, without a specific backer apart from a bootstrapping period.This will allow digitally holding value tied to physical assets.

What characterizes colored bitcoins in comparison with other methods to achieve the samegoals is that it is entirely built on top of the infrastructure of Bitcoin (or some otherblockchain-based currency) – the tokens are any bitcoins that can be traced back to a par-ticular output, and the transactions in which tokens are moved are Bitcoin transactions,recognized as normal transactions by oblivious Bitcoin nodes but must satisfy additionalrequirements to be considered legitimate by color-aware nodes.

The structure of this work is as follows: In chapter 2 we examine the advantages anddisadvantages of this system over alternatives. In chapter 3 we explain some of the detailsof tracking the color of coins.

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Chapter 2

Merits of colored coins

2.1 List of benefits

There are many use cases for colored coins, and many alternative methods to satisfy them;it will be useful to first list the potentially beneficial features of the colored coins method.

1. Colored coins are very general. Virtually any kind of asset or contract can be repre-sented using them.

2. They can be stored digitally without needing a third party. In particular, the fullforce of the Bitcoin scripting language can be mustered for their safe storage, such asmulti-signature transactions.

3. They can be transferred digitally to a new owner with no need for central authorization,which has implications for ease of use, efficiency and availability.

4. They can be exchanged for other colored coins or uncolored bitcoins in a single atomictransaction – meaning there is no counterparty risk, even without blockchain confirma-tions. And once again the entire range of scripting options is available to allow morecomplex trades, such as exchanging for coins of a different blockchain with a similarsecurity guarantee, or automated escrow.

5. Properly used, ownership of colored coins can be made anonymous, while still enjoyingthe benefits of ownership.

6. The infrastructure of technology, software, hardware and services which powers Bitcoincarries naturally to benefiting colored coins. Technical challenges that are overcomewith Bitcoin translate to the colored coins platform; software for handling Bitcoincan be used, with or without patching, to handle colored coins; mining hardwarewhich synchronizes Bitcoin transactions automatically also synchronizes colored coinstransactions; and various Bitcoin-related services can be used in the context of coloredcoins, sometimes while remaining color-unaware.

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7. The intuitions behind dealing with Bitcoin translate to understanding the colored coinplatform, and together they form the “common language”, on both discussion andsoftware levels, to tie up the various applications.

2.2 Comparison with alternative methods

Many of the use cases could be accomplished, to some extent, using methods other thancolored coins. We will list some such methods and emphasize the advantages that coloredcoins may have over them.

1. Traditional stock exchanges. The traditional ecosystem of stock exchanges andbrokers serves today for the issue and trade of financial instruments, and was provenin the test of time to be viable for this purpose. However, old established businessestend to suffer from lack of innovation; these platforms pose a significant barrier of entryto smaller issuers; and the lack of a truly digital representation for the assets has allthe usual disadvantages with regards to transaction fees, availability, self-sufficiencyand so on.

2. Modern central services. Start-ups such as GLBSE ([2]) attempted to use thepower of Bitcoin to provide a modern, international, low-cost alternative to traditionalmarkets. Such a lean platform could mitigate some of the disadvantages of centraliza-tion. However, it is by far more exposed to others: As was widely suspected in the caseof GLBSE and eventually turned out correct, the lack of track record and regulatorycompliance exacerbate the risk of unclean shutdown, throwing asset issuers and holdersto limbo.

3. Dedicated blockchain per asset. The Bitcoin technology allows the creation ofnew blockchains with relative ease, each representing its own alternative currency. Anissuer could create a new blockchain where the units of currency are tokens of his asset.If the different blockchains conform to some standard, a single software could handleseveral of them with a convenient interface.

However, this greatly increases the barrier to entry and misses an opportunity foreconomies of scale in the security of cryptocurrencies. Different cryptocurrencies workbest if they pool their hashrate, as each of them enjoys the security of the combinedhashrate. This can be achieved with merged mining; however, this still requires someamount of hashing native to the currency, as well as support of some miners from thehost blockchain (such as Bitcoin). Smaller issues with few users will find it difficultto enjoy protection from hashrate-based attacks. Also, the host blockchain will notbenefit from the native hashing of the guest blockchains.

Furthermore, for such smaller issues, there will be few nodes storing, verifying andserving blockchain data, posing a risk to network integrity and availability. Even ifenough nodes can be found, a software client handling several asset types will need toconnect to several nodes of each, increasing the networking overhead.

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It also makes it more difficult to send dividend and coupon payments (in bitcoins orother currency or asset) to the owners of assets.

By having the assets embedded in the Bitcoin blockchain, the entire existing infras-tructure of Bitcoin network nodes and miners can be utilized to benefit each and everyone of the assets. This allows creating a secure asset with no barrier to entry. Theextra burden on the host network can be paid for with a proper transaction fee system.The inclusion of arbitrary assets in the Bitcoin network will increase its total economicvalue, attracting more nodes and miners to strengthen it even further. Payments toasset holders can be done directly to the holding address in either the host or any guestcurrency.

4. Separate asset-aware blockchain. This is similar to the above, except a singleblockchain (unrelated to existing blockchain currencies) will be used for all assets.This is in fact a variant of, not an alternative to, the concept of colored coins, ascoloring will still need to be used to track specific assets within this blockchain. Itsadvantages are that it can spare the host blockchain from any real or perceived illeffects, and that additional features can be developed for it to make it more friendlyfor its intended purpose.

However, this variant is slower to bring to market, as the infrastructure needs to bebuilt from scratch rather than leveraging the Bitcoin infrastructure.

5. Open Transactions. Open Transactions ([4]) is a powerful platform that can satisfymost, if not all, of the desired use cases. However, its intuitions are different thanthose of Bitcoin, which means it will likely be more slowly adopted by the Bitcoincommunity (who is the primary target market for the features we are espousing) thana Bitcoin-based system. It can still exist as a viable alternative, with its own pros andcons, to a colored coin system.

2.3 Demerits of colored coins

We should also consider (and in some cases, refute) the suggested disadvantages of the coloredcoin system, specifically when embedded in an existing blockchain.

1. Blockchain bloat. The inclusion of the extra burden of colored coin transactionscan supposedly bloat the blockchain, increasing the cost of running a node. However,scalability is an issue for any blockchain even with only native transaction, and is anissue which should be solved rather than worked around. Every transaction carriesthe marginal cost of being received, verified and stored by every node on the network.These are all commodities, an transaction fees exist in part to pay for them. With aproperly chosen system for the distribution of fees to nodes, any additional transactionmakes it that much more lucrative to run a node, maintaining the balance of thenumber of nodes and their profitability. In fact, since new economic activity can bear

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above-cost fees, it can serve to actually strengthen the network. The overall level offees is a protocol-level decision to balance the number of nodes with the reductionof friction; whatever level is chosen, additional layers can be used to accommodatetransactions with a lower value than the threshold (for both the native currency andcolored coins).

2. Insufficient hashing fees. More difficult than the problem of funding network re-sources, is the problem of funding hashing. Since the cost of hashing is amortized overall transactions, it is essentially a bargaining game between miners and users, whichunconstrained would lead to a race to the bottom. As such it will be useful to haveprotocol-enforced methods (such as a limit on the total value of transfers per block)to make sure fees are paid by those who can afford them (typically senders of high-value transactions). With colored coins, the network is unable to determine the valueof the transactions and charge accordingly. This means what this economic activitycontributes to the hashing network is not proportional to, and typically lower than, thevalue it obtains from it. However, no actual harm will be done by colored coins; andwhile a system which does contribute fairly would be preferable, unless such a systemcan be come up with, this objection is moot.

3. Legal concerns. With colored coins embedded in a host blockchain, any legal issuewith the guest assets, such as uncertainty about security trade regulations or specificunsavory assets, might project into the host blockchain. This issue deserves moreexploration, but it is the author’s belief that the inclusion of multiple heterogeneousentities within the same blockchain will only reinforce its position as defying traditionallegal approaches.

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Chapter 3

Implementation overview

The foundation of colored coins is the ability of an issuer to set aside some of his bitcoinsand declare that they have a specific color, and state his obligations to owners of coins ofthis color. “Color” is used metaphorically, of course - in practice a color will be identifiedby a ticker symbol and a unique hash.

The crux, then, is the method to determine whether bitcoins held at some future timeare of this color or not. The issuer should be able to send these coins to another party whilemaintaining their color identity. That party should be able to send them to yet anotherparty, and so on. It should be impossible to have coins recognized to be of the color in anyother way to receive coins which were already of this color, following a chain of transactionsthat can be traced back to the color’s genesis.

The fundamental unit of account in Bitcoin is an output – the issuer will declare oneor several of his outputs as belonging to the color, and then every output which can betraced back to them will also belong to this color. By default, bitcoins are fungible at theintra-transaction level; when a transaction has multiple inputs and multiple outputs, theprotocol does not dictate a correspondence between particular inputs and outputs. Even ifa transaction has an input recognized to be of a certain color, there is no way, in general, toidentify specific outputs as successors which inherit this color.

This is possible, however, by requiring a certain structure for color-aware transactions,and having a specification for how to parse such transactions – that is, how to determinethat given outputs have given colors. For such a specification to be valid, it will need tosatisfy the conversation laws, that it is possible to move coins but impossible to create themout of nothing (by anyone but the issuer). With this in place, verifying that an output isof a certain color is simply a matter of examining the transaction it is part of, determiningwhich inputs need to be of this color, and recursively verifying that indeed they are, all theway to the genesis outputs (there may be more computationally efficient methods to achievethe same result).

A naive solution would be to require that all inputs must be of the same color, and thatin this case all outputs are of this color too. However, with this system transaction fees needto be paid out of colored coins, which are much more valuable than their underlying Bitcoinvalue as recognized by the network. This also misses out on some important applications,

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such as atomic transactions with coins of multiple colors.The standard of choice for the structure of color-aware transactions is order-based col-

oring. It has several extensions to deal with various use cases, but in its simplest form, itrequires that:

• Inputs and outputs are sorted by color, with uncolored coins at the end.

• The same order of colors is used for both inputs and outputs.

• For each color, the total value of all inputs is equal to the total value of outputs; onlyuncolored coins can have a greater input value than output.

To parse such a transaction, we go over the different colors in order. For each color wesum up the input values of this color. Then we go over each output in order and assign itto this color, until the total output value is equal to the input value. By requirement, alloutputs of the first color appear first, and their total value is equal to the total input value;hence, we will eventually reach an output which brings the total to match exactly.

Then we move on to the next output in the list and the next color, assigning outputsto it until the total output value of this 2nd color is equal to the total input value; and soon. After all colors have been exhausted, the remaining outputs will be uncolored; if thetotal uncolored outputs value is less than the input, the rest will be transaction fees. (Theuncolored outputs will be no more than the uncolored inputs because this is a valid Bitcointransaction.)

Note that colored transactions are a special case of Bitcoin transactions. A valid Bitcointransaction which does not follow the special colored format, will be recognized by the Bitcoinnetwork, but not as a legitimate color-preserving transaction by the colored coin network.The color of these coins will be lost, and hence users and software clients need to be carefulto avoid doing this and losing their value.

Example: Suppose we are given a transaction with the following inputs and outputs:The computation will proceed as follows:

Index Inputs Outputs#0 13 Red 3#1 6 Green 6#2 4 Green 4#3 9 Blue 10#4 2 Blue 3#5 8 Uncolored 8#6 5#7 2

First color: Red. Total Red input value: 13.

Output #0 is Red. Total Red output value: 3.

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Output #1 is Red. Total Red output value: 9.

Output #2 is Red. Total Red output value: 13. Red is complete.

Next color: Green. Total Green input value: 10.

Output #3 is Green. Total Green output value: 10. Green is complete.

Next color: Blue. Total Blue input value: 11.

Output #4 is Blue. Total Blue output value: 3.

Output #5 is Blue. Total Blue output value: 11. Blue is complete.

Total uncolored input value: 8.

Output #6 is uncolored. Total uncolored output value: 5.

Output #7 is uncolored. Total uncolored output value: 7.

No more outputs. Total uncolored output value is less than input value.

Difference of 1 BTC is transaction fee.

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Bibliography

[1] Mike Hearn. Smart property. https://en.bitcoin.it/wiki/Smart Property. Retrieved onOct 30th 2012.

[2] James McCarthy. Glbse. https://glbse.com.

[3] Satoshi Nakamoto. Bitcoin p2p virtual currency. http://www.bitcoin.org/.

[4] Fellow Traveler. Open transactions. https://github.com/FellowTraveler/Open-Transactions.

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